Circular Flow of Economic Activity

Readers Question I am having trouble understanding the circular flow of economics. Could you explain it in simple terms, like how is it involved in my life, I don’t get the connection to the product and factor markets

The circular flow of income is a simple model to explain basic economic transactions.

To start off, consider 2 groups of people

  • Households – people like yourself
  • Firms – companies like BMW, Vodafone e.t.c.

Simple flow

Circular Flow

  1. Householders (people like you or me) could get a job in a factory making cars. This leads to an output of goods.
  2. In return, workers get income (wages) from the firm.
  3. With this income, we can buy the goods firms are producing. This is Expenditure.

Thus in a closed economy with no saving, tax or imports. Total Output should be the same as Total Income and Total Expenditure.

  • Note: Factor markets are markets like labour markets.
  • Product markets are the production of goods like cars

Therefore, this is the very basic circular flow of income.

Government tax and spending

  • To this circular flow, you could add a government which collects taxes from firms and households.
  • The government then spends this money in the form of benefits and subsidies.

Foreign trade

Also, you could add a foreign dimension.

  • Goods and services could be exported – Money comes into economy
  • Goods and services could be imported – Money leaves the economy

Also, we don’t spend all the money we receive, but will save some in banks. Firms could borrow from banks to invest.

7 thoughts on “Circular Flow of Economic Activity

  1. You cycle omits the accumulation of capital, which means that income does not equal expenditure.

    Becasue of this inequality inceasing levels of debt/leverage are require to maintain household income and make income equal to expenditure

    put it simply: capital accumulation implies credit bubbles

  2. Really nice, dude. Like i tried to read from the professor’s notes, i couldn’t understand it very clearly. You gave a clear picture. thumbs up. 🙂

  3. Thanks now I know it,,,I dont jst understand it better but I know it…surely I can explain 2 others..u r a star thank you tons

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